Is Southwest’s Low-Cost Model Being Threatened By AirTran’s Integration?

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Southwest Airlines (NYSE:LUV) has one of the lowest operating expenses per mile of an aircraft flight among the major U.S. airlines. This is due to its strategically designed low-cost model which allows it to offer lower fares – its biggest competitive advantage historically. However, is this low-cost model being threatened because of the company’s integration with AirTran? We think so.

The critical features of Southwest’s low-cost model are point-to-point flight operations, focus on secondary airports and operation of a single aircraft type – the Boeing 737. However, AirTran operates on a hub-and-spoke model, has several primary airports in its network, and operates a different aircraft type – the Boeing 717. As a result, the AirTran integration is impacting Southwest’s low-cost model by increasing its operating expenses.

On the bright side, AirTran also offers several benefits to Southwest such as significant growth opportunities on AirTran’s Latin American routes. Additionally, in the domestic U.S. market, the flight networks of the two carriers are highly complementary.

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We currently have a stock price estimate of $9.54 for Southwest, marginally above its current market price.

See our complete analysis of Southwest here

Addition of an aircraft type

Southwest’s fleet is entirely composed of Boeing 737s. The operation of a single aircraft type translates to lower operating expenses as it simplifies training, scheduling and flight operations. In comparison, AirTran’s fleet is mainly comprised of Boeing 717s. Hence the addition of an aircraft type increases several cost heads such as spare part inventory management, maintenance  activities and training costs. The cost heads are lower for a single aircraft type compared to multiple aircraft types.

Addition of primary airports

In addition, Southwest’s operations are focused on secondary or downtown airports such as Dallas Love Field, Houston Hobby, Chicago Midway, Baltimore-Washington International, Burbank, Manchester, Oakland, San Jose, Providence, Ft. Lauderdale/Hollywood and Long Island Islip. These airports, in addition to having lower airport and landing fees, are typically less congested compared to primary airports. Lower congestion allows for higher aircraft utilization as the aircraft spends comparatively less time on ground. This is turn reduces the number of aircraft and gate facilities required and allows for higher employee productivity (headcount per aircraft). On the other hand, AirTran’s network has a much higher proportion of primary airports. This has the potential of increasing airport and landing fees and reducing aircraft utilization.

Southwest’s point-to-point operations vs. AirTran’s hub-and-spoke operations

Southwest operates on a point-to-point service model. As a result, it has a greater number of direct flights which burn less fuel compared to connecting flights through a hub city. On the other hand, AirTran operates on a hub-and-spoke model. Nearly half of its flights originate or terminate at its largest hub, which is Hartsfield-Jackson Atlanta International Airport. This will increase Southwest’s average fuel costs, thereby impacting its ability to offer lower fares.

On the bright side, AirTran acquisition provides near-term growth opportunities

However, the AirTran acquisition is also beneficial for Southwest as it provides near-term growth opportunities and significantly increases Southwest’s market share in the domestic U.S. market. AirTran’s operations on Latin American routes have significant growth potential as the demand for flights on these routes is increasing driven by the fast-growing economies of Latin America. The route networks of the two carriers are also highly complementary. For instance, AirTran’s biggest hub city is Atlanta and Southwest had no flights to and from Atlanta at the end of 2011.

Nonetheless, Southwest’s biggest competitive advantage is its low-cost model and the AirTran integration is impacting the same. In order to retain this advantage, the network operations between the two carriers will have to be optimized and this could take a long time.

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